In the backwash of the French and Dutch rejection of the EU constitution, which I believed was a good thing for the future of the EU, there have been scattered voices predicting either a collapse of the EU or a splintering of the common currency, the euro. One British commentator, noting that each euro has an identifying mark that tells in which country it was printed (just as each Federal Reserve note indicates which of the 12 Fed districts issued it), it would be easy enough for Italy, for example, to break loose from the system and return to the lira, exchanging them at some devalued rate of exchange. In the London Daily Telegraph, columnist Charles Moore wrote last week that the German magazine Stern advised readers to get rid of their Italian euros and keep their cash in the safer euros, those marked with an "X" for Germany:
Stern's X-factor advice was based on the idea that the euro zone might break up. When the euro began in 1999, it was glorious for Italy, Spain, Portugal and (prospectively) for Greece. Their interest rates halved. Boom followed. But those countries had not abolished their inflationary habits when they abolished their currency, and now they had lost their old remedy of devaluation. As a result, their competitiveness is collapsing. Italy`s competitiveness against Germany has fallen by a quarter since 2000. Within the system today, all that Italy could do is to deflate, but in the resulting squeeze, revenues would fall, causing the deficit to explode. Real wages would have to be cut to compete with Germany. The politics would be horrible.
It could happen, but it won't. As I observed in my letter last week, "Doing Europe a Favor," it might take four or five years for the Europeans to work things out: "If they asked my advice, I'd tell them it would be easier if they first eliminated the unknowns caused by their floating currency, a point I have been making for almost 30 years." In the Epilogue of The Way the World Works, which I wrote on Sept. 30, 1977, I noted that Margaret Thatcher was promising to slash income-tax rates as soon as the Tories returned to power, and that the economic expansion that would follow would ripple across Europe, giving courage to conservative coalitions in other capitals to follow her lead. "It will then occur to European political leaders in general that the Common Market idea can move ahead only if the internal tax structures of the European nations are made roughly similar, so that a European common currency will not have variable impacts on output and employment through its effects on tax progressions."
The Eurocrats have actually come quite a way since 1982 in rationalizing their individual tax systems, but there is still plenty of variation. Germany`s top corporate tax rate is 25% and Ireland`s is 12.5%, Italy`s 33%. The VAT tax rates vary slightly, most around 20%. We no longer see top income-tax rates in the 70% range, most at 40% or so. The bigger problem is the floating euro, which, while not swinging as widely as the dollar in recent years, has a variable impact on the debt structures of the different countries. Italy is probably still paying a price for the lira`s unpredictability, with a shorter maturity of its debt structure. All of Europe would be growing faster if it eliminated future inflations and deflations of the common currency by fixing the euro to gold. Of all the EU countries, Ireland is the one that has best figured out that if it can`t devalue its currency to raise the level of economic activity, it has to rely upon tax- or pro-growth regulatory policies to do the job. The Eurocrats in Brussels hate the Irish for taking this route, on the grounds that if all countries in the system had equal after-tax incomes, there would be no need for capital and labor to migrate to the most favorable state. Everyone should be middle-class together. Such was the motive force behind those who wrote that 285-page constitution.
In the U.S., we have been stuck with the floating dollar since 1971, and you must have noticed over these 34 years the acceleration of capital and labor migrations. I particularly remember that when the price of oil quadrupled in 1973, following a four-fold rise in gold, there were more opportunities for capital and labor in Texas and fewer in Michigan. Autoworkers packed up and re-settled their families in the oilfields. In the deflations that followed, the flows reversed. Nowadays, the migration is from California, where the dopes in Sacramento put the state income tax up to 10% while Nevadans have zero tax on income and capital gains. As our Wayne Jett noted in his California report yesterday, the number of millionaires in the state has dropped to 30,000 from a high of 50,000 and the dopes in Sacramento want to raise taxes again.
As wobbly as it is against gold and the dollar, the euro remains a great achievement, one of the bright spots in the EU economic system. Back when each country had its own currency, remember, a tourist hitting several countries in a month would lose as much as 30% of his purchasing power in the cost of changing money at every border. Just imagine the costs of money changing across borders in normal international trade. This is what led Robert Mundell to say decades ago, at the beginning of the floating era, that "the gains to be had from a common currency are so great that mankind will always find a way to one." That doesn`t mean the exact same currency for the world. They can still have different names and shapes and colors from one sovereign country to another, but they have to be common in their relationship to gold.
My expectation is that the draft EU constitution will go back to the drawing board and more or less gather dust until some political leader comes forward with a Mundellian philosophy about how it should all fit together. Can France`s new prime minister, Dominique de Villepin be that political philosopher? He has impressed me greatly in a field of Eurohacks and Poodles. Meanwhile, I`d think we could expect more rationalization of tax and regulatory systems across EU boundaries, reducing the capital and labor flows from the more serious currency wobbles. If non-inflationary growth resumes at a healthy clip, with the entrepreneur getting the breaks instead of the corporatist, we might also expect an unraveling of at least the excesses of the welfare state. When capitalism breaks down, ordinary people opt for socialism, but when capitalism works the way it is supposed to, ordinary people will nudge their leaders away from the welfare state.